Ten Myths About Token Sale Regulation in Hong Kong
By Pádraig Walsh, Last updated: 2023-01-18 (originally published on 2019-05-15)
No part of the tech universe has a greater abundance of myths than the crypto space, and no part of the crypto space has a deeper black hole of urban legends than the weird and wonderful world of token sales. Here are some of the myths I have encountered.
Myth #1: The tokens will be issued outside Hong Kong. So there is no problem in Hong Kong for the rest of the project.
Let’s assume for argument sake the token is classified as a security under Hong Kong law.
It will be a regulated activity to promote the purchase of the token in Hong Kong or to actively promote it to people in Hong Kong from somewhere else. Similar principles apply if you are advising people in Hong Kong to purchase the tokens. If the project is classified as a collective investment scheme, then management of the platform is a regulated activity.
The white paper and token sale conditions could be classified as documents that are an invitation to subscribe for a regulated financial product. That may need regulatory approval.
There are exemptions from these regulations, and some may be helpful. But the key point is that moving the token issuing entity outside Hong Kong does not mean Hong Kong law won’t apply.
And that is only looking at securities law; other laws can and do apply.
Myth #2: Hong Kong regulation won’t apply, so long as I exclude Hong Kong participants from the offering.
Excluding Hong Kong participants from the token sale should avoid the regulation of documents that are an invitation to the public to subscribe for a regulated financial product. But that only deals with document regulation. Securities law focuses on regulated activities also.
The primary focus of the regulation of activities is whether activities are conducted by people in Hong Kong. This remains the focus even if those activities are directed at people outside Hong Kong.
There is an issue in Hong Kong once there are feet on the ground in Hong Kong.
Myth #3: It’s a utility token. So it’s unregulated.
It’s not about the label. Many projects make the assertion that the issued tokens are utility tokens. A bold assertion that is not backed up by substance is just a label.
When it comes to deciding if a token is a security, then call it what you will: if the tokens function like a security, then rule of thumb: the tokens are a security.
What then are utility tokens? Utility tokens are not investments, but rather are tokens whose sole or core function is to permit future access to or use of a product or service that will be made available on the platform. The utility element should be embedded into the early planning of the platform, and should be critical right from the start. The utility token should not function outside the platform for which it was created. Its value should be linked only to the demand for the products or services on the network, not the performance of the underlying operator. The classic use case for a utility token issued in a token sale would be similar to coupons for pre-ordering goods. “Buy the token now, and exchange it for products and services on our platform later.”
Sometimes the regulatory interpretation can change even if the token functions as a utility token. Here are two examples.
1. Secondary market: Many tokens can be immediately or imminently sold in a secondary market, and converted to fiat currency to realise a gain or return. This increases the risk that the initial purchase of the token was for the purpose of gain or return. This is a characteristic of a security.
2. Marketing: The risk of classification as a security also increases if the marketing and promotion of the token emphasizes gain or return over the utility function.
Also, the nature of a token can change over the course of its life. A utility token today could function as a security token in the future.
Verdict: Somewhat true, but mostly false.
Myth #4: The token has some utility. So it’s unregulated.
A number of projects start with no utility in the original design, but then in subsequent iterations, some utility is added. Often, the project has no driving need to be on blockchain, but the attraction of raising easy money brings the moth to the flame. In these projects, utility is marginal, usually uncommercial, and always ill-conceived. So, does the simple presence of some utility mean the tokens are not securities?
Think of the range from security tokens to utility tokens as a sliding scale. There are elements of grey, and there are few, if any, pure utility tokens. But the tipping point is most likely the other direction. Some elements of being a security is more likely to result in the token being a security. This is so even if there are significant or even substantial elements of utility in how the token operates.
The utility of the token must be its sole, critical or core function for there to be a reasonable prospect that it will not be a security.
Myth #5: The platform is decentralized and autonomous. No-one is responsible.
There are two embedded beliefs in this statement. First, that the platform is decentralized and autonomous from birth to boneyard. Second, that the only concern is whether the tokens represent an equity security or a debt security.
An organization may be decentralized and autonomous, but it is not without human actors. Some human actors will achieve a level of influence that is significant and becomes the chief ingredient of the success or failure of the network. The founders and first promoters of a network will often be core service providers to the network. If the service providers have the discretion to propose, make and implement key decisions, then that can amount to a form of centralized authority. It may not matter if other participants on the platform can participate in a decision, have the right to veto a decision, or are passively consulted. It is a question of substance, not form.
DAOs may be decentralized and autonomous as a matter of technology, but may not be as a matter of law.
Verdict: Somewhat true, but mostly false.
Myth #6: It is not an equity security or a debt security. Nothing else to worry about.
In Hong Kong, securities include an interest in a collective investment scheme. Good articles on this topic by my colleague, Russell Bennett, can be checked out here and here. Be warned, it makes for scary reading.
The characteristics of a CIS are:
1. A CIS can be any arrangement. It is not limited to any specific form. It can include a network, platform, or DApp, and how they operate.
2. The arrangement can be in respect of any property. It is not limited to cash or fiat currency. It can include intangible personal property – which is property with no intrinsic value, but which is representative of value. Intellectual property is a form of intangible personal property. A blockchain platform is intangible personal property. Tokens are intangible personal property. The purpose of the network and the rights that tokens represent will also involve property.
3. Participating persons in the arrangement do not have day-to-day control over the management of the property. It is not enough that participants are consulted, or that they can give directions. The participants must actually, as a matter of fact and substance, manage the arrangements on a day-to-day basis. Decisions must be initiated, decided and implemented by them, not a third party. The key factors are not what is written in the White Paper or the Token Conditions. It’s about what is happening on the ground. It’s a question of fact and substance, not what’s the theoretical underpinning or even what is in the contracts. Purchasers of tokens and token holders are participating persons.
4. Either one or both of:
(a) The property is managed as a whole by or on behalf of the person operating the arrangement.
Management of the property as a whole is a critical phrase. The Howey Test refers to the expectation of profit solely from the efforts of others. This has led to some commenting that the input or effort of participants would take a network outside the scope of the Howey Test. Hong Kong law is much broader. The marginal input of participants, or the right to provide input, won’t make them “managers”. Participants have to be making operational decisions consistently and as a matter of fact.
The questions to ask are:
(i) What is the property? Take this scenario. Property is sub-divided into smaller individual units, and each unit is then allocated to a specific participant. What is the property? Well, if the activities that yield the profit or income for participants are conducted in respect of the property as a whole, and not distinctively for each unit, then the property will be the whole property before sub-division.
(ii) What activities constitute management of the property? These activities include the routine, everyday decisions that make the whole thing tick. So, referring only big decisions to participants will not be enough.
(iii) Who is effectively performing those activities as a matter of fact? If the person performing the management activities is doing so on behalf of the operator, and not the participants, then the criteria are fulfilled.
Also, an operator is different to an owner. The operator of the arrangement does not need to have any ownership interest in the investment vehicles. The operator could simply have a contract to provide services or a right to appoint a person to do so, if those services amount to managing the property as a whole.
(b) The contribution by participating persons, and the profits or income of the arrangement, are pooled.
Features of pooled investments include the contribution of funds by participating persons to a single aggregated account, the calculation of contribution or the assessment of costs by reference to the property as a whole, and the payment of profits or income by reference to the property as a whole (without regard to individual variations).
5. The purpose or effect, or pretended purpose or effect, of the arrangement is to enable participating persons to receive either:
(a) returns represented to arise or likely to arise from the property (or any part of the property), or sums represented to be paid or likely to be paid out of those returns (or part of those returns); or
(b) returns arising from any right, interest, title or benefit in the property or any part of the property.
The phrase “purpose or effect” is broad. The purpose or effect of an arrangement can include arrangements where returns to participating persons from the property in question are likely, even if that is neither the intention nor primary objective of the operator. Also, the purpose or effect of an arrangement will be assessed by virtue of how the arrangement is run in practice, and not necessarily by how the arrangement is described in contracts or legal documents.
An arrangement can be a collective investment scheme, even if no returns are made or the returns are derived from another source than the property. The critical feature is what has the operator represented in respect of likely returns.
So, let’s apply this to a blockchain network. A software development company operating in Hong Kong develops a concept for a decentralized platform based on using the increased purchasing power of the network to get discounts on products. This operating company decides to conduct a token sale in and from Hong Kong. The shareholders of the operating company form a company limited by guarantee in Hong Kong, which is a not-for-profit entity. Founders of the operating company are members of the Board of Directors, together with independent non-executive directors. The guarantee company appoints the operating company to develop and operate the platform. The guarantee company will issue tokens (via the platform) to purchasers. The tokens will be inactive until the platform is available, and then may be used to purchase the discounted products. A token sale is made to the public. A proportion of available tokens are reserved for the Founders. Tokens may be traded on crypto-exchanges, and converted to fiat currency. Funds are used to build and develop the platform.
Is this a collective investment scheme? Let’s see.
1. This is an arrangement.
2. It is in respect of property. Here, the property is the blockchain platform.
3. The participating persons do not have control of the property. The participating persons are the purchasers of tokens in the token sale.
4. The operators of the arrangement are managing the property as a whole. Also, the proceeds of the token sale are pooled. The operating company and its founders are the operator of the arrangement.
So far, so clear. Now, here’s the nub.
5. Is the purpose or effect to enable participating persons to receive a return either from the blockchain platform itself, or from a right in respect of the blockchain platform?
The value of a token represents both the right attached to it (e.g. the right to purchase discounted goods), and the value of access to the community or network on the blockchain platform. The value of the token rises and falls according to the level of participation on the blockchain platform. This rise and fall in value is speculative, fluctuates, and is more akin to an investment than a simple utility function. This investment function of a token is enhanced if the token then becomes tradable in a secondary market, and even liquid and convertible to fiat currency. This is often built into the design of the token and the smart contract for the token sale.
So, doesn’t the purpose or effect of the token sale of a utility token include (at least) enabling participating persons to make a return from a right in the blockchain platform?
This is where the innovation at the heart of using blockchain platforms runs right into a regulatory crux. It is possible that even token sales in respect of utility tokens could be considered a collective investment scheme. If so, promoting and advising on the token sale is a regulated activity, as is managing the blockchain platform. Likewise, the issuance of token sale conditions would be subject to regulation.
The position is far from clear. Must the right in question be an ownership right? Owning a token is not ownership of the blockchain platform. Is the position different if token holders participate in governance of the blockchain platform? What level of governance by participants is needed? What if the operators do not emphasise the secondary market available for token sales, or restrict its availability, or prevent conversion of tokens to other crypto assets or fiat currency? What if the operator acts via a not for profit entity, so it could argue it is not engaged in a business? All valid questions. There is no definitive answer based on current regulation in Hong Kong.
But the risks are high. The one safe solution is to treat all token sales as regulated. But then, doesn’t that stifle the innovation at the heart of this technology – the democratization of project fundraising?
Verdict: Most likely false, but may be true in very limited cases (once regulators make interpretation of the rules more clear).
Myth #7: Apart from securities law, there are no other laws I need to worry about.
Here are some laws that either definitely apply, or at least may apply:
- Anti-money laundering and counter-terrorist financing laws
- Corporate laws
- Director and officers laws
- Tax laws
- Contract law
- Laws on misrepresentation
- Consumer protection laws
- Privacy laws
- Intellectual property laws
- Cybersecurity laws
- Money service and transmission laws
- Payment service and stored value laws
- Lending laws
- Gambling and pyramid scheme laws
And this is not exhaustive.
Myth #8: I am going to use SAFT. So I don’t need to worry about regulation till the public sale.
SAFT (the Simple Agreement for Future Tokens) starts from the principles that SAFT is an investment contract and those entering into the SAFT are accredited investors for a Regulation D offering under US securities law. So, SAFT worries about regulation from day one.
SAFT is prepared with US securities law in mind. Offering SAFT to potential purchasers in Hong Kong must also comply with Hong Kong securities law. So, a buyer who fulfills accreditation criteria for a Regulation D offering, may not fulfill the criteria for being a professional investor for the offering of securities in Hong Kong.
Also, if the conduct of offering the SAFT, and related promotion and marketing, is conducted in Hong Kong, then that may be a regulated activity for which a licence is needed.
One of the principal reasons why SAFT is considered an investment contract under US securities law, is that its value depends on the essential efforts of the developers, and not the direct effort or use of the buyers. This is one of the elements of the Howey test. Hong Kong law approaches the issue differently. Hong Kong law is more likely to assess whether the project in development would constitute a security (including a collective investment scheme), and if so, consider the corresponding SAFT a security. The fact that those who enter into a SAFT will have no control over the development (or most likely, operation) of the platform, and will not receive a functional token at that time, increases the chance that the arrangement is considered a security. Ultimately, the position in Hong Kong needs to be checked on a case-by-case basis.
Best recommendation for developers: don’t use an unmodified SAFT in Hong Kong unless you take advice from a Hong Kong lawyer first.
Myth #9: I’ll run the pre-sale through my current operating company, and then transfer it all across later. That’s ok, right?
I have heard founders float this approach by saying:
We need to move fast. We can work out the structure later. So, let’s do the pre-sale in our present company so we can catch this opportunity while the timing is ripe.
These founders are willing to flout good process to chase fast, easy money. Cutting corners before a project is even started would not fill me with confidence for the stewardship and success of the project. Also, this shows an unhealthy disrespect for rules and regulations.
We don’t want to take on the cost of implementing the overall structure until we have funding for it.
Understandable. This is why the best advice is to conduct an angel or seed equity round to properly set up the best structure, and fund the cost of the token sale.
We haven’t fully worked out what we will do, but we need funding now to continue our preparation. The current operating company is what we’ve got, so let’s go with that.
Let me translate. This means the founders may change the proposition for the platform after the pre-sale has completed. So, those participating in the pre-sale will not know what they are buying. Again, conduct an angel or seed equity round for funding. The rigour of external investors will focus the mind.
There is no harm to my operating company, because if the pre-sale does not go well, I can just give the funding back.
The big hairy misconception here is that the only risk is financial loss capped at the amount of funding. Not true. The pre-sale is subject to the same considerations of law and regulation as the main token sale. Some consequences could even be criminal. Also, will the money be there?
There are good reasons for separating an operating company servicing the platform from the issuing entity in the token sale.
There may be more lenient regulatory treatment, or tax efficiencies, in selecting particular jurisdictions as the location to set up the issuing entity. Disregarding that at the pre-sale stage is foolish. There is risk contagion. The risks of the pre-sale are being mixed with the current operating company’s business. Token sales are high risk. The existing core business may not be. Mixing both may result in both being lost.
The pre-sale amounts to a promise to issue discounted tokens in the main sale or to activate pre-functional tokens in the main sale, and tokens cannot be used or traded until the main sale is completed. The operating company must be able to deliver on its promise. If it can deliver on its promise, then it’s a sign the operating company controls the platform. This has regulatory consequences.
It may not be possible (or at least easy) to transfer later. In some structures, the issuing entity will not be owned or controlled by the operating company. There will be a separation of governance in how both entities are managed. Then, the operating company will not have the ability to deliver on its promise in the pre-sale. So what value has the promise made in the pre-sale?
A proper pre-sale will be conducted from the same issuing entity as in the main sale, and the entire token sale structure will be in place before the pre-sale starts.
Myth #10: I’ll do an STO. Then, regulation is not a problem.
Security token offerings (STOs) focus on the accreditation of token buyers, to ensure they are allowed by securities regulation to participate in the offering. But, the persons conducting the offering may also be engaged in regulated activities when promoting the STO (and managing arrangements afterwards), and may need to be licensed in their location to perform that activity.
If an STO is conducted in multiple locations, then the STO must comply with securities offering regulation in each of those locations. Compliance with US securities offering rules does not mean Hong Kong rules have been complied with, and vice versa. So, a global or almost global STO, though not impossible, is certainly not practical or commercially viable.
Bonus Myth: Token sales are faster/easier than an equity raise.
Token sales that don’t take heed of law, tax or the interests of token buyers can be conducted very fast, and may be as easy as stealing candy from a baby. But those token sales are likely to have broken laws, will not have credible governance, and may be fraudulent. Fast and easy may have been the experience in the early days of token sales, but it is not true now.
Remember, if it’s too good to be true …
It takes a minimum of four months, and usually six months or longer, to properly conduct a token sale. This involves:
- assessing the use case of the platform
- building the project team
- engaging the adviser team
- working out the token sale corporate structure
- considering the tokenomics of the token sale
- initial consideration of platform governance
- assessing legal and regulatory issues
- considering the tax position
- building the technology
- preparing the white paper (and possibly, the technical white paper)
- drafting the token sale conditions, and related documents
- considering and executing the token sale marketing strategy
- conducting the token sale
- getting tokens listed on exchanges (if necessary)
This is a very light outline of the process. But even taking it at face value, each aspect is substantial and complex work. A proper token sale is not a project to be taken on lightly. The many elements of it are such that the crypto-equivalent of investment bankers are cropping up, and the good ones are badly needed. Projects of this nature need astute, reliable and experienced project managers to deliver them successfully.
Logically, a token sale should not be faster or easier than an equity investment round. The funding raised is intended to deliver the cost of set up and operation of an entire operating platform and business; not just funding to the next staging post.
The care, forethought and planning involved should reflect the grander intention and longer deployment for the funds raised in the token sale.
Also, the comparison is misconceived. Equity investment injects capital to fund businesses; token sales raise funding to deliver projects.
Padraig Walsh is a Partner at Tanner DeWitt specialising in Corporate & Commercial, Financial Services Regulation, Notarial Services. Thank you for reading. Find out more about what I do here.
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